The Fed is About to Hammer U.S. Oil Producers

The market is moving up nicely today, as investors continue to play a Whac-a-mole version with the cute little creatures replaced by not-so-cute members of the Federal Reserve Board.

As the debate intensifies over whether the Fed is raising interest rates or not, the U.S. energy sector, already under pressure, is about to feel a whole lot more of it.

It makes no difference if the Fed raises rates in June, July, or September (nothing happens on this front in August). And it makes no difference whether we end up with only one or two more hikes this year.

Any way you look at it, a wide swath of U.S. oil and natural gas producers are going to take it on the chin. Bankruptcies, mergers and acquisitions, and asset sales one step ahead of the sheriff will be increasing.

That doesn’t mean there’s no profit to be made here… On the contrary, in fact. But it does mean we have to tread carefully… 

Credit is Crucial to U.S. Energy Companies

Now, much of this would be happening anyway, thanks to the protracted global competition keeping prices (for now at least) hovering just below the $50 a barrel figure. But a Fed move to raise interest rates – and we will certainly not make it through 2016 without this taking place – will speed up this process.

It’ll be another nail in the coffins of many operators.

Another round of what is misleadingly called “creative destruction” is well underway.

The collision between Fed interest policy and U.S. oil and gas operators remains centered on a matter we have discussed here in Oil & Energy Investor on a number of occasions.

Virtually all U.S. publicly traded or privately held oil and gas producers have been “cash poor” for some time. This simply means that they have been spending more for new drilling projects than they have been getting in current cash flow.

The difference (including operations costs) has primarily been covered by debt.

This is not as strange as it may seem at first read. When oil prices were north of $70, this was a very manageable arrangement.

Cash was reserved for other purposes, such as dividends, contract buy-outs, stock buy-backs, and a myriad of other purposes. With oil at such levels, credit was easily obtained with (if necessary) the company’s reserves used as collateral (at a discount).

Rolling over a more or less perpetual debt actually improved returns to investors by assuring forward operations.

Not so today.

Banks are About to Review (and Rethink) their Energy Debt

The ability to use oil that hasn’t been drilled yet as security for a line of credit becomes problematic once the price that oil can command declines significantly – and then remains at such low levels.

That accurately describes a period of more than sixteen months that ended only recently.

By then, the energy component of the high-risk (read: “junk”) bond market had deteriorated considerably.

There are two “spreads” to consider here. The first is the separation between interest charged on investable credit, and that charged on credit considered to be high-risk. Second is the difference between high-risk bonds in general and the worst performing bonds in that category.

This last component is energy.

The situation is even worse once you factor in what happens every quarter (or even more frequently during times of considerable volatility). Every three months, banks review and adjust their loan portfolios, which determines the size of the credit lines they extend to borrowers.

For energy companies, the worst-case scenario is that their credit line gets reduced to less than they credit the company has already drawn on. This requires already cash-strapped energy companies to quickly pay back the difference, or default.

But any reduction in available credit is bad for companies (like today’s U.S. oil and gas operators) that simply aren’t bringing in enough cash to pay their bills. So is a change in credit terms, including higher interest rates or a less lenient repayment schedule.

Now, another one of these bank reviews is approaching – just as the Fed springs into action…

A Whole Lot of Companies are About to Disappear

The bottom line is this: currently, few if any energy companies can obtain new debt at less than 21% annualized interest. And that’s before the Fed increases the borrowing interest floor for everybody. When that happens, you don’t simply add 25 basis points (0.25%), the widely-held expectation for the next rate hike, to the present rate.

Rather, those two spreads I mentioned earlier will magnify the difference as better paper noses out the lesser. Energy debt (once again, the worst of the high-risk category) will be hit by another whammy.

An improvement to above $50 a barrel will have no impact here. The number of insolvent companies will increase disproportionately to the actual increase in the annual percentage rate (APR).

Keep that in mind when you hear the analysts that are now saying that oil prices will be sustainable at $60 or more by the end of this year. For many companies this is going to be too little too late.

At such higher sustainable prices, matters will begin stabilizing. However, by that point there will be fewer players in the space to benefit.

This environment offers great potential for profits in the energy sector – picking those winners now could set you up for huge gains.

But you’ll need to be mindful of the widespread credit risk among U.S. oil and gas operators. Thanks to low oil prices and the Fed, you now have to choose your investments with even more care than usual.

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